Bank of America too much of a behemoth to fail

The Obama administration says the Dodd-Frank financial reform law ends “too big to fail,” meaning that no financial institution will ever again need to be bailed out. The promise is alluring, but it’s already proving to be false.

The argument rests on the premise that bank capital is now high enough to withstand serious shocks, so a calamity is less likely. It also assumes that Dodd-Frank’s new resolution authority allows global financial institutions to be wound down in an orderly fashion, and that the law’s call for “living wills” ensures that banks provide all the necessary technical details regulators might need to take prompt pre-emptive action.

Consider the law’s promise in the context of Bank of America Corp. Through the back door, U.S. regulators are facilitating another round of implicit bailouts, putting more taxpayer money on the line in the form of guarantees. Bloomberg News reported on Oct. 18 that regulators have allowed Bank of America to move highly risky derivatives contracts ― and the associated downside risk ― from Merrill Lynch into the insured retail deposit-taking part of the bank.

The move puts the Federal Deposit Insurance Corp. on the hook for any losses. The FDIC’s deposit-insurance funds come from its member banks, but because the agency can tap a U.S. Treasury line of credit if the fund runs dry, taxpayers could be at risk, too.

This condones the continuation, or perhaps escalation, of taxpayer-backed gambling on a grand scale ― and by people who aren’t very good at it. The U.S. is heading in the direction of Western Europe, where state-backed banks repeatedly bring everyone to the brink of disaster. Consider, for example, UBS AG’s recent rogue-trading episode.

Bank of America is a behemoth beyond control. The destruction of shareholder value in its recent history is shocking. The Wall Street Journal reported on Oct. 19 that the bank has spent $148 billion on acquisitions since 1998 and today its market value is only about $65 billion.

Bank of America is also a badly managed bank. In 2008, Ken Lewis, then the chief executive officer, agreed to pay about $4 billion to buy Countrywide, a disastrous foray into mortgage origination and distribution that will probably end up costing shareholders more than $60 billion. Eric Schneiderman, the New York state attorney general, is calling for a full investigation of mortgage abuses; egregious and allegedly illegal behavior at Countrywide must be very much in his sights.

Lewis bought Countrywide after a year’s worth of due diligence ― what was he thinking? ― and then grabbed Merrill Lynch over a weekend in September 2008, apparently without much thought. Significant additional losses were the result.

Why the FDIC would agree to escalate taxpayer subsidies now is a puzzle. According to people familiar with the situation, the Federal Reserve pressed for this move, which required an exemption from the usual rules. This outrage demands immediate congressional investigation.

Does Bank of America have enough capital to avert disaster? From its third-quarter results, it has $2.2 trillion in assets, making it the second-largest bank in the U.S. The book value of its tier-one common equity is about $117.7 billion ― hardly a robust buffer against the shocks that appear likely from mortgage litigation and from the European debt disaster. Investors believe that much of this capital will be wiped out ― hence the lower market valuation.

A large chunk of its most recently reported profit actually turns out to be due to the decline in the market value of its debt, precisely because investors realize it is in so much trouble. This ludicrous application of accounting standards should raise major flags for regulators.

If Bank of America really had enough capital, it wouldn’t have needed to move its derivatives risk onto its FDIC-insured deposit business. Nor would the Obama administration be strenuously resisting the New York attorney general’s efforts to organize a full and fair mortgage settlement based on all the facts.

Could the resolution authority be used on Bank of America? Definitely not in a way that would bring calm to the markets. Merrill Lynch is a global business and the resolution authority is purely domestic. I have discussed this point repeatedly with U.S. legal and financial experts and with members of the Group of20 nations. Their opinion on this point is unanimous: The Dodd-Frank resolution authority doesn’t help manage the orderly liquidation of a global bank.

There could be a conservatorship, but that is just a long word for full creditor bailout. Or there could be a bankruptcy, with the kind of disorganized collapse seen after the failure of Lehman Brothers Holdings Inc. Those are the choices.

Could the living-will provision make a difference? The FDIC claims it would have handled the problems at Lehman differently if the Dodd-Frank powers had been in effect and if it had full and timely information. But the essence of the argument is that the FDIC would have acted before the problems got out of control. Given the politics of the regulatory process and the predisposition of Treasury not to act early, I am skeptical.

So here is a fair test for this part of Dodd-Frank. Bank of America should clearly be broken up into pieces, spinning off Merrill Lynch along with other structural changes. Will the regulators pursue this course of action? Breaking up the bank would be good for the country, should help stabilize the financial system and could even create value for its shareholders.

Such an action would draw support from both the right and the left. Republican presidential candidates should be drawn to this position (apart from Mitt Romney, who has already taken a lot of money from big banks). So far, the only one to have identified “too big to fail” as a problem, and proposed a course of action, is Jon Huntsman.

When will other politicians and regulators awake from their current complacency? Bank of America should be forced to break itself up. Make the pieces small enough and simple enough to fail. Then let the market decide. 

By Simon Johnson

Simon Johnson, who is a professor at the MIT Sloan School of Management, is a Bloomberg View columnist. The opinions expressed are his own. ― Ed.

(Bloomberg)